What it is:
A bank run occurs when a flood of depositors withdrawsfrom a bank within a short time frame.
How it works/Example:
It’s important to remember one thing about banks: They don’t keep your deposit in a bank, the bank lends a portion of those to people who want loans for houses, cars, businesses or whatever else. Accordingly, depositing $100 into your bank account doesn’t there is $100 sitting in the vault.
By lending out deposits, banks make in the form of interest. However, they must keep a portion of those deposits on hand at all times to support the day-to-day inflow and outflow of funds that depositors need.
Let’s say John Doe reads a rumor on the Internet that Bank XYZ is going to go bankrupt. Worried about the money in his checking and savings accounts there, John runs over to the bank and withdraws all of his money. He also tells his sister, his nephews and his parents, who also withdraw their money. Rumors of Bank XYZ’s demise spread over the Internet like wildfire. Soon, more people withdraw their funds or transfer them to other banks.
The rumor is not true, and Company XYZ is in fine financial health. But by this point, Bank XYZ has given out so much from its vault that now it really is having a hard time fulfilling the withdrawal requests from its customers. The news goes national, and every depositor of Company XYZ hears that you’d better get your money out now before there’s none left. The downward cycle continues.
Eventually, the withdrawals reach a point where Company XYZ is drained of , actually does become financially unstable and goes under. The run becomes a self-fulfilling prophecy.
Why it matters:
Bank runs can destabilize the banking system quickly, which is why the Federal Reserve sets a reserve requirement for banks. For example, let’s assume that Bank XYZ has $400 million in deposits. If the Federal Reserve’s reserve ratio requirement is 10%, Bank XYZ must keep at least $40 million in an account at a Federal Reserve bank and may not use that for lending or any other purpose. This ensures that Bank XYZ always has some on hand to prevent a run. If a bank is unable to meet its reserve ratio, it can borrow from the Federal Reserve to meet the requirement.